The Fed is most likely to announce the second phase of quantitative easing (QE) in the policy statement after the conclusion of the November 2-3 FOMC meeting. The minutes of the September 21 meeting indicate an extensive discussion about the unsatisfactory pace of economic recovery. The utmost importance of taking action to promote economic growth was visible in the repetitive mention of the need for additional monetary accommodation. The following excerpts from the minutes support expectations of further Fed action at the close of the November 2-3 meeting.

“Participants discussed the medium-term outlook for monetary policy and issues related to monetary policy implementation. Many participants noted that if economic growth remained too slow to make satisfactory progress toward reducing the unemployment rate or if inflation continued to come in below levels consistent with the FOMC’s dual mandate, it would be appropriate to provide additional monetary policy accommodation.”

“Several members noted that unless the pace of economic recovery strengthened or underlying inflation moved back toward a level consistent with the Committee’s mandate, they would consider it appropriate to take action soon.”

“Members generally thought that the statement should note that the Committee was prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate. Such an indication accorded with the members’ sense that such accommodation may be appropriate before long, but also made clear that any decisions would depend upon future information about the economic situation and outlook.”

The discussion of suitable strategies to provide monetary accommodation appears to have concluded with the focus on “further purchases of longer-term Treasury securities and possible steps to affect inflation expectations.” Inflation expectations, as measured by the difference the 5-year Treasury note yield and the 5-year yield on inflation protected securities (see chart 1) has risen from a recent low of 1.19% on August 19 to 1.41% as of October 8. An increase of inflation expectations lowers real short-term interest rates and stimulates economic activity. With nominal short-term interest rates constrained by the zero bound, an increase in inflation expectations is important to lift economic activity.

As noted in prior commentaries, the precise terms of QE2 are unclear and the Fed is unlikely to announce the magnitude of accommodation as this is the path already taken when it engaged in QE1. The policy statement will probably reflect the Fed’s full employment and price stability mandate as guidance for the extent of support it plans to provide. For QE2 to work, banks need to move away from accumulating excess reserves. Excess reserves have been trending down from a peak of $1.192 trillion of February 24, 2010 to $964 billion as of October 6 (see chart 2).